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Introduction

The Pensions Regulator has today issued its annual funding statement in respect of how it expects defined benefit occupational pension schemes to be funded. The funding statement provides the sponsoring employers and trustees of defined benefit pension schemes with guidance on how the assets and liabilities of those schemes should be valued and how any funding deficit should be eliminated. The funding statement has been provided against the backdrop of the current economic climate. This includes consideration of the impact of quantitative easing and the resultant reduction in yields from Government-backed securities (gilts), which have caused significant increases to many pension schemes’ funding deficits.

The guidance is aimed at approximately one third of the UK’s 6,500 defined benefit occupational pension schemes which the Pensions Regulator assesses will be undertaking actuarial valuations with an effective date between September 2011 and September 2012. The Pensions Regulator states that trustees and sponsoring employers that follow the guidance will be more likely to reach funding agreements which are acceptable to the Pensions Regulator and which do not necessitate regulatory involvement.

Reliance on anticipated improvements to gilt yields

A number of pension schemes and pensions professionals had called for the Pensions Regulator to allow schemes to take account of the possibility that gilt yields will improve in the future, once economic conditions have changed. This would have the effect of reducing a pension scheme’s liabilities at the valuation date. However, the Pensions Regulator considers that such a change to calculating a pension scheme’s technical provisions (i.e. its liabilities) would not be a prudent approach, as it seeks to second guess future market conditions. The Pensions Regulator states that it considers such an approach would not be consistent with the legislative requirement to value assets on a mark-to-market basis.

Despite this, the Pensions Regulator does not rule out completely reliance on anticipated improvements to gilt yields. However, the Pensions Regulator expects such reliance only in exceptional circumstances. Any changes to a funding plan based on this reliance must be backed up by “viable contingency plans” (which should be “suitably documented”) in case the anticipated improvements do not occur. The guidance does not set out what would be considered to be a “viable contingency plan” or what constitutes suitable documentation. As such, these aspects of the guidance currently remain unclear.

Extending recovery plan periods

Instead of relying on anticipated investment performance improvements, the Pensions Regulator considers that the statutory scheme funding framework has significant flexibility to enable pension schemes and their sponsoring employers to meet their long-term liabilities. This flexibility includes the possibility of spreading deficit-reduction contributions over a longer period, taking account of post-valuation improvements to market conditions, in addition to the use of contingent security and intra-group guarantees.

The Pensions Regulator estimates that the majority of pension schemes and sponsoring employers will not need to make significant changes to their deficit-reduction contributions and/or the length of their recovery plan (if at all) to reflect the reduction in gilt yields. However, there will be a significant number that fall outside this category. Whilst some sponsoring employers may be able to afford additional contributions or be able to put in place additional security, other sponsoring employers will find this a challenge.

The Pensions Regulator’s guidance states that, where a sponsoring employer is unable to pay additional deficit-reduction contributions in respect of a larger funding deficit, trustees may agree to a longer recovery plan. Trustees may also agree to a longer recovery plan if a sponsoring employer’s covenant has weakened and it cannot afford to continue contributions at previously agreed levels. However, the Pensions Regulator will require “sound justification” for any material extensions to recovery plan end dates.

Conclusion

The Pensions Regulator has indicated that it will be robust in determining whether a sponsoring employer is genuinely unable to afford increased deficit-reduction contributions. In determining this, the Pensions Regulator will seek to ensure that the competing demands of a sponsoring employer are treated equitably, such that other stakeholders (for example, other creditors and shareholders) are not advantaged at the expense of the pension scheme. As such, the number of pension schemes in respect of which the Pensions Regulator will accept longer recovery plans is likely to be significantly lower than the third of 6,500 defined benefit occupational pension schemes at which the guidance is aimed. Indeed, some commentators estimate that this number will be around 300.

Broadly, we believe that the Pensions Regulator’s guidance is helpful for both sponsoring employers and trustees, particularly given the difficult financial conditions which currently prevail. As ever, the devil will be in the detail, so each pension scheme’s funding will have to be considered on its own circumstances.

The full version of the Pensions Regulator’s annual funding statement can be found here.